Securitization of Loans and Mortgage Backed Securitization

The main reason for the Sub Prime Crisis was not bad loans but securitization of these mortgage loans, this process is known as Mortgage Backed Securitization (MBS). This raises the main issue like
· What is Securitization?
· What is Mortgage backed securitization?

Securitization
Thirty years ago, if you got a mortgage from a bank, it was very likely that the bank would keep the loan on its balance sheet until the loan was repaid. That is no longer true. Today, the party that you deal with in order to get the loan amount is highly likely to sell the loan to a third party. The third party often then packages your mortgage with others and sells the payment rights to investors who are willing to invest in such securities. This may not be the final stop for your mortgage. This can continue for additional steps. The process by which most mortgage loans are sold to investors is referred to as Securitization.
In the mortgage market, securitization converts mortgages to Mortgage Backed Securities. Securitization is a process, which involves pooling and repackaging of cash flow producing financial assets into securities that are then sold to investors. It is the process of conversion of existing assets or future cash flows into marketable securities. In other words it deals with conversion of less liquid assets into more liquid ones.
Conversion of existing assets into marketable securities is called Asset Backed Securitization, whereas the conversion of future cash flows into marketable securities is called Future Flows Securitization. Similarly, when the mortgage payments are securitized it is called as Mortgage Backed Securitization. Example of assets that can be securitized is housing loans, car loans, credit card payments etc. Example of future cash flows that can be securitized are car rentals, lease rentals etc.

Mortgage Backed Securitization (MBS)

In layman’s term, Mortgage Backed Securities (MBS) is a mortgage backed/secured by one’s asset wherein one looses the ownership of the asset on default of payment. In the traditional lending process, bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower’s creditworthiness. This requires banks to hold assets up to the maturity. The funds of the bank are blocked in these loans and to meet its growing fund requirement a bank has to raise additional fund from the market. Securitization is process of freeing up these funds blocked in loans.
To free these blocked funds, the assets are transferred by the originator (the lending bank) to a special purpose vehicles (SPV). The SPV is a separate entity formed exclusively for facilitation of the securitization process and providing funds to the originator. In order to fund the purchase, SPV issues tradable securities to banks, mutual funds, other financial institutions and government. The performance of the securities is then linked to the performance of the assets.
The assets transferred to the SPV need to homogeneous in nature, i.e. only one type of loans (say housing loans) and of similar maturity period (say 20-24 months). These assets are bundled together for creating the securitized instrument. The SPV will act as an intermediary which divides the pooled assets of the originator into marketable securities.
The securities issued by the SPV to the investors are known as pass-through-certificates (PTC). The cash flow received (principal, interests etc) by the originator from the borrowers are passed on to the investors on the pro rata basis. The difference between the rate of interest being charged from the borrowers and the rate of return promised to the investors in PTC is the servicing fees for the SPV.
The originators are generally responsible for collecting the repayments from the borrowers and passing it on to the SPVs.

There are three major risks to MBS investors.

· The first is interest rate risk and it is common to all bondholders. The investors invest in these securities because they carry higher return as compared to other bank deposits. Also, the valuation of these securities is important for the investors as their decision for purchase lies on them. These valuations have an inverse relationship with the interest rate in the market. Higher the interest rate, lower is the value for MBS and vice-versa.
· The second risk is prepayment risk. Many mortgages in the United States can be prepaid without penalty. If they prepay the loan when the interest rate is low, the banks will have to issue fresh loans at the current market rate which would eventually lead to lower return for the IB and thus lower returns to the investors of the securities
· The third risk faced by MBS investors is default risk—that is, the risk that homeowners will default on the mortgages that back the MBS. Private sector MBS issuers may obtain direct insurance against default, but often they structure their MBSs to allocate default brisk toward parties willing to bear it. This risk was overtaken and misjudged in the US’s MBS Market which led to Sub-Prime Crisis.


Re-securitization

Mortgage-backed securities are not the end of the line. Pools of MBSs are sometimes collected and securitized. Bonds that are themselves backed by pools of bonds are referred to as Collateralized Debt Obligations (CDO). The CDOs can look like MBSs, except that the underlying assets are bonds in case of a CDO as against some physical assets in case of MBS. Structured Investment Vehicle (SIV) is similar to CDOs. The difference between SIVs and CDOs is essentially in the type of debt they issue. The SIVs are structures backed by pools of assets, such as MBSs and CDO bonds. The SIVs issue short- and medium-term debt rather than the longer-term debt of most CDOs. The short-term debt is referred to as asset-backed commercial paper.